Performance Management accounting

CUAC 411 Modules

Design of Management Accounting systems

Planning, Controlling and Decision Making

Hierarchy

-Planning, controlling and decision making can be classified into tree levels namely:

1. Strategic Planning

 The process of developing long term plans for the organisation that is 5-10years or
more
 This mainly concerns new products to be launched, new markets to be developed etc.
 It is planning and decision making done at board level and this tends to be an outline
rather than detailed planning.

2. Management Planning/Tactical planning

 A more detailed short-term planning for example one year budget in order to ensure
resources are obtained and used efficiently to achieve the long term plans of the
company.
 This focuses on future staff needs of the company
 Control is then exercised against the budget using the aspect of variance analysis.

3. Operational Control

 The day to day management of the business in order to ensure that specific tasks are
carried out effectively and efficiently for example ensuring that budgeted production
has been achieved effectively.
 The information used will be very detailed and will be quantitative but will often be
expressed in terms of time taken that is hours or output for example units instead of
in monetary terms.

Strategic Planning
  The strategic plan covers the following

Vision

MISSION

GOALS AND OBJECTIVES

ENVIRONMENTAL
CORPORATE APPRAISAL
ANALYSIS
POSITION AUDIT

STRATEGY CHOICE

STRATEGY IMPLEMENTATION
VISION

 This is a much broader way of predicting the future of an organisation

Mission Statement

 An expression of the overall purpose and scope of the organisation which is in line with
the values and expectation of the stakeholders
 It answers the question; what sort of business are we/do we want to be?
 A mission statement will generally cover or contain 4 the elements :

1. Purpose
 -what and for whom the company exist for?

2. Strategy
 The range of business in which the firm seems to compete and some indications of how
it intends to compete.

3. Polices and Behavior Standards

 These are the guidelines which help staff decide what to do on a day –to –day basis to
carry out the strategy.

4. Values
 These are the beliefs and moral principles which lie behind the firm’s culture.
 The purpose of the mission statement is to communicate to stakeholders, the nature
of the organisation and to focus strategy.
 However, in practice, there are generally full meaningless phrases.
 Taking an organisation of your choice, briefly outline its mission statement.

Goals and Objectives

 -Goal is broader than objectives, these are also known as aims of the entity.
  Goals and objectives are often put together without any distinction made between
them.
e.g. of goals could be to improve profit or to reduce costs.
 However, goals are statements of general intention where as objectives are more
specific or targeted.
 An objective could be to achieve a 10% return on asset or a 10% mark-up /margin
within 6 months 1 year, 2 years etc.
 - Objectives must be smart (specific,measurable,attainable,realistic and time –bound)
 Example of financial objectives are :for the next 12months :
 To increase operating profit by 20%.
 To increase return on capital employed by at least 15%.
 To cut net losses to below 0, 5%.
 Examples of goals:
 To be a clear leader in the market.
 Achieving biggest growth in volumes/meeting higher customer satisfaction.

Corporate Appraisal
 It is a critical assessment of the strengths, weaknesses, opportunities and threats in
relation with the external and internal factors affecting an organisation.
 The purpose is to establish the condition of an organisation prior to preparing a long-
term strategic plan.

Position Audit
 This assesses the strength and weaknesses of the company by asking questions such as:
what are we good/bad at?
 In particular, existing products will be reviewed and consideration given as to which
products should be continued /promoted and which ones to be phased out
/abandoned.
 0ne thing to be considered in relation to each pr0duct is as to where it is positioned
currently on its product life cycle.
Diagram
  If the product is currently in the maturity /decline phase, the company needs to
develop strategies for replacement of the product in the long term rather than relying
on its continuing profitability.

NB. The pricing methods used depend on whether they are appropriate to the circumstance in
which they are used.

 It may be appropriate to charge the same price as competitors, e.g if customers

perceive different producers` products as largely generic since no significant are
achieved.
 In situations where competition is limited ,competitors ‘s prices provide no real
yardstick and hence full cost +mark up provides the way of arriving at a fair price
which is reasonable relative to cost of production.
 The general problem with adhoc approaches to pricing is the danger that the pricing
approach used in particular circumstances will not be appropriate in other
circumstances, will not serve the company’s strategic objectives and ultimately will
be sub-optimum.
 The proposal to adopt a strategic approach to pricing (is a very good one especially
where it is started that there is no intention to lock the company into one particular
approach to pricing.

Possible Strategies to pricing

1. Pricing permanently a product at a level in excess of competitors’ comparable
product.
 This is only feasible as part of product differentiation strategy. Here, the supplier
needs to convince customers that its products are superior to those of competitors
and hence the need for customers to pay extra for superiority.
 However shrinking consumer incomes may cause few customers to accept to a
price premium and hence this lowers profitability of the entity.
2. Setting a high price in early months of a product’s life cycle and reducing the price
for the remainder of the cycle.
 The technique is used for ensuring that enthusiastic ‘early adopters (those who are
not price sensitive) pay a higher price for the product.
  The approach is not suitable for regular items like food where profitability is
achieved through customer frequency and repeat purchases.
 It is also not proper where competitors offer similar products.
3. Charging a low price in the early months of a product’s life cycle and then increasing
the price for the remainder of the product’s life cycle. (Addictive products).
 It is a good way to penetrate a market where the key to profitability is to ensure that
customers make repeat purchases.
 The low initial price will encourage customers to try new products and this becomes
an effective way of gaining market share.
 Subsequent increases in selling price provide profitability although price sensitive
customers may be lost at this stage.
 The strategy is effective in building customer loyalty to a differentiated product.

4. Selling a product at loss throughout its life cycle

 This is desirable if it facilitates the profitability of some other product ranges.
 Example, in order to obtain shelf space from a bread retailer there may be need to a
comprehensive range of bread products for various allergy sufferers.
 The major goal is to achieve overall profitability of many products rather than an
individual product from the distribution channel.

5. Bundling Products
 This is a way of concealing individual product prices from the customer.
 The profitability of a bundle can be assessed by comparing its sale price with the
combined production and distribution costs of the products in the bundle.
 While bundles may be profitable, the customer is forced to buy some products which
may be unwanted.
 Difficult strategy to sustain since their opportunities for competitors to offer
customers the chance to buy similar products individually rather than purchase the
entire bundle.
 A potentially useful approach to considering each existing product is to position them
on a Boston Matrix Grid.

Market share
 High low

STAR QUESTION MARK

CASH COW DOG

GROWTH

Low high

QUESTION MARK
 This generates income but consumes more so we have aggressive marketing to turn
product into cash cow.
Cash Cow
 This is a well invested product and this generates income, all you have to do is to
maintain the low growth.
Dog
 Is a product that no longer generates cash

STAR
 Generates cash but consumes all what it generates and investment is needed to turn
products to cash cow.
 N.B. Having positioned the products on the grid, it can then be used to consider future
strategy for each of them.
 An environmental analysis can be carried out which identifies the opportunities and
threats presented by the external environment.
 These are summarized as PEST analysis.
Additionally (esp. when launching a new product) consideration may be given to Porter’s 5
forces model i.e.:
 Threat new entrance
 Threat of substitute
 Bargaining power of buyers
 Bargaining power of suppliers
 Rivalry between competitors

 The Ansoff’s product market matrix can also be used.

 This is commonly used by businesses that have growth as their main objective and is
used to focus management attention on the four main alternative (strategic) available
for growth.

Existing products new products

Existing market Market penetration
EXISTING MARKET PRODUCT

PENETRATION DEVELOPMENT

MARKET

MARKET PRODUCT

NEW DEVELOPMENT DIVERSIFICATION

MARKET

|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||\\\\
  Having carried out the position audit and environmental analysis the task is to develop
the strategies in order to:
1. Convert weaknesses into strength
ii) Convert threats into opportunities.
iii) Match strengths and opportunities
 The exercise is commonly

 A SWOT analysis helps in identifying suitable strategy

 To assist in identifying sufficient strategies, a gap analysis is also required.

 Diagram

 The types of strategy that can be adopted in order to fill the gap are:

 Cost saving measures

 Becoming more efficient
 Making changes to the product /the market matrix, this could be by
organic or by acquisition
 Withdrawal.
Strategic Choice
 Having carried out a corporate appraisal and having identified potential strategies, it
is then necessary to appraise them and formulate a strategic plan.
 The types of techniques that may be employed in appraising the strategies are :

i) Strategy Implementation
 The strategic plan will generate the formulated on the board level and once it has
been prepared, managers of the company are then expected to implement it.
 The management will then carry out tactical planning0r management control.
II) Free Wheel Opportunitism
 This occurs where the company deals without a strategic plan but operate a
system where the opportunities are exploited as they arise.
 The major advantage is that opportunities can be sized as they arise.
 The major drawback is that it cannot guarantee that all opportunities are
identified and appraised.
TARGET COSTING
Historical Background
 It originated in Japan in the 1970s, it came to being as a result of recognition that
customers were demanding more diversity in products that they bought and the life
cycle of the products were getting shorter.
 As such, it meant that new products had to be designed more frequently.
 Companies realised that the larger proportion of costs were committed in the design
stage of the product and hence the design stage become critical for the company to
make profit.
Purpose
 Target costing is a method that is employed to manage costs and profits.
 It involves setting a target or objective for the maximum of a product /service and
working out now to achieve this target.
 It is used for business strategy and marketing strategy in particular by companies who
operate in a competitive environment and where new products are continuously being
introduced.
 For companies to achieve these, they need to:
 Continually improve their existing products or design new ones.
 Sell their products at a competitive price just like competitors or slightly
below competitors.
 Make a profit.
NB in order to make a profit, companies need to make the product at a cost below the
expected sale price.

Target costing and New product Development

 It is mainly used for new product development; this is due to the fact that whenever a
new product is designed and developed for a competitive market, a company needs to
know what maximum cost to be placed on a new product so that it will sell at a profit.
 Keeping the cost of the product within the target level is the major factor in
controlling its design and development.

New product design and development

Setting target cost
 $
Target selling price xxxx
Less target margin xxx
Target cost xx

 The reason that target costing is used for new products is the opportunities for cutting
costs to meet target costs since it is from the design stage and development that all
production processes are set up.

Target costing method

 The principles of target costing can be summarized as:
 Target costing is based on the idea that when a new product is developed ,a company
will have a reasonable idea about:
i) The price at which it will sell the product.
ii) The sales volume that will be able to achieve for the products over its product life.
iii) Their may be need to estimate capital investments, incremental fixed costs such
as marketing costs and additional salaries.
 Taking estimates of sales volumes, capital investments, incremental costs over the life
of the product, it then becomes easier to ascertain the target cost.
 The target cost for the product might be the maximum cost for the product that will
provide at a least a required return on the investment.

Elements in Estimates Cost and Target Cost

 It is difficult to measure the cost of a product that has not yet been created and the
cost must include such items as raw material wastage, direct labour idle time which is
expected to occur in normal circumstances.
Raw material
 The target cost should allow for expected wastage rates/wastage in the process.
 The price of raw material should also allow for any possible increase up to the time
when the new product development is completed.
 Estimating price of raw materials can be difficult in inflation times when prices are
subject to large price increases within short periods.
Labour
 Target cost should allow for any expected idle time that occurs during the
manufacturing of the product.

Production Overheads
 A target cost could be a target marginal cost or full cost.
 Production overheads, in some cases make up a large portion of the total
manufacturing cost and as such target cost should be based on full cost.
NB Activity based costing can be employed to absorb costs rather than the traditional
methods.

Example
 A company has designed a new product, chicken lick; it currently estimates that in the
current market, the product could be sold for $70.00 a unit. A gross profit margin of
30% on the selling price would be required to cover administration, marketing
overheads and also make an acceptable level of profit. A cost estimation study has
produced the following estimate of production cost for chicken lick.

Cost item
I. Direct material m1 $9/unit
Direct material m2 each unit would require 3kgs of material m2 but there will be a loss
in production of 10% of the material used. Material m2 cost $1.80 per kg. Direct labour –
each unit of chicken lick will require 0,5hours of direct labour time. However, it is
expected that there would unavoidable idle time equal to 5% of total labour time paid at
$19 per hour.
Production overheads –it is expected that production overheads will be absorbed to
production cost at a rate of $60 per direct labour hour for each labour hour worked
(overheads are not absorbed into cost of idle time)

Required
To calculate:
i) Expected cost per chicken lick.
ii) Target cost for chicken lick
Iii) The size of the cost gap
Solution
 Production cost of chicken lick

a) Expected cost of the product $

Direct material m1 9.00
M2(3kg*$1.80*100/90) 6.00
Direct labour- (0.5hrs*$19*100/95) 10.00
Prime cost 25.00
Production overheads ($60*0.5) 30.00
Expected production cost 55.00

b) Calculation of target cost

$
Selling price 70.00
Minimum expected return (30%*70.00) 21.00
Target cost 49.00

c) Cost gap = expected cost –target cost

= 55.00 -49.00
= 6.00
 The company needs to identify ways of closing the gap.

Closing the cost gap

 Common methods of closing the gap are:
 To redesign products to make use of common processes and components that is
already used in the manufacture of other products by the company.
 To discuss with key suppliers on the methods of reducing material costs.
 To eliminate non value added activities or non value added features of the product
design.
 To train staff in more efficient techniques .improvement in these reduces costs.
 To achieve economies of scale (buying and producing in bulk.
 To achieve cost reduction as a result of the learning curve effect that is through
experience curve effect.
Advantages of target costing
 It helps to improve the understanding within a company 0f product cost.
 It recognizes that the most effective way of reducing costs is to plan and control cost
from the design stage onwards.
 It helps to create a focus on the final consumer for the product or service because of
the concept of value.
 It can be used together with recognized methods for reducing costs such as JIT,
process engineering, and total quality management.

Implications of target costing

 Target costing can be used with the pricing policy for a company or service.
 It assists in cost control and performance measurement that is
 Cost savings are actively sought and made continuously over the product ‘life
cycle.
 There is joint responsibility for achieving benchmarking that is if one
department fails to deliver the cost saving expected, other departments may
find ways to achieve the savings.
 Staff are trained and empowered to find ways of reducing costs while
maintaining product quality.

NB Target costing is likely to succeed in company where there is a culture of continuous

improvement.

Limitations
1. It is sometimes unrealistic hence unachievable targets are set.
2. May demotivate workers if they fail to meet their targets.

Practice questions
PRODUCT LIFE CYCLE COSTING /WHOLE LIFE CYCLE COSTING
 This is a costing method that considers the cost of a product or on an asset over its
entire marketable or useful life.
 Life cycle costing tracks and accumulates costs and revenue attributable to each
product over the entire product life cycle.
 It can be applied to:
 Products that are introduced to the market and then manufactured and sold
over a number of years until they are eventually withdrawn from the market.
 Building and other major construction items whose cost change over their
useful life from construction to eventual demolition.
Life cycle cost
 Cost of a product or asset over its useful life can be categorized into 3 namely:

1) Acquisition costs—these covers set up costs or market entry costs.

 Costs are incurred initially to bring the product into production and start selling it
or the costs incurred to complete the construction of a building or other
construction assets.

2) Operational costs or running costs

 These are costs incurred throughout the life of the asset or product. Examples of
such costs are repairs and maintenance, advertising e.t.c.

3) End of life costs

 Costs incurred to withdraw a product from the market or to demolish the asset
after its use full life.
 Acquisition /setup costs are mainly’one-off’,are once –off capital expenditure and
once off only costs such as cost of training staff ,establishing systems of
documentation and performance report.
 It should also be noted that end –of –life costs are also once –off costs that is they
occur just once.
 Running costs and operational costs are regular and recurring annual costs throughout
the life of the product or asset.
  However, these costs may vary overtime for example maintenance and repair cost of
equipment such as elevators in a building industry which are likely to increase as
equipment ages.
 Although costs are incurred throughout the life span of an asset, a large proportion of
these costs are incurred or committed at a very early stage of the product’s life cycle
when the decision to develop the new product or construct a new building is made.

The product life cycle

 Most products made in large quantities for selling to customers go through a life cycle.
 A life cycle consists of several stages:
 Research and development of the product(design and development stage)
 Introduction to the market
 Growth in sales and market size
 Maturity
 Decline
 The product is finally withdrawn from the market.
Detail stages

Example of whole life costing

 Romantic ltd specializes in the manufacture of invertors .it is planning to produce a
new inverter specially designed for small houses. Development of the new inverter is
to begin shortly and Romantic ltd is in the process of determining the price of the
inverter. It expects the new product to have the following costs ;

Year 1 2 3 4
Units manufactured 3000 12000 18000 7000
$ $ $ $
Research and Development 1800 000 200 000 ---- ---
Marketing costs 150 000 50 000 25 000 15000
Production cost/unit 650 450 350 300
Customer service cost/unit 40 30 30 30
Disposal specialist equipment 350 000
 The marketing Director believes that customers would be prepared to pay $480 for an
inverter but the Financial Director believes this will not cover all the costs throughout the
products ‘life cycle.

Required
Calculate the cost /unit on the whole life cycle and comment on the suggested price.

Solution
PRODUCT LIFE CYCLE COSTING.
Total cost
$
Research and Development (1800 000+200 000) 2 000 000
Marketing costs (150 000+50 000=25 000+15000) 240 000
Production costs [(650*3000)+(450*12000)+(350*18000)+(300*7000)] 15 750 000
Customer service [(40*3000)+(30*12000)+(30*18000)+(30*7000)] 1 230 000
Disposal of specialist equipment 350 000
Whole life cycle cost 19 750 000
Out put for the period (3000+12000+18000+7000) 40 000
Cost/unit (19570 000/40 000) 489.25

The proposed price will not cover all the costs therefore the company has to redesign
their product so that it reduces the cost per unit.

Implications of using whole life cycle costing

 By using this method, we consider all costs incurred in the manufacturing of the
product, this is different from the traditional methods which concentrate on the
internal costs only.
 Research and Development costs are written off as they are incurred.
 Profits are measured on a time/annual basis rather than on whole life under tradional
methods.
 Non –production overheads are not linked to products but written off as general
expenses under traditional methods. However ,life cycle costing compares the
 revenues and cost of the product over its entire life and the benefits accruing there
from are;
 Potential profitability of products can be assessed before major development
of the product is carried out and the costs are incurred thereby enabling
elimination of non-profitable products.
 Techniques can be used to reduce costs over the life of the product.
 The pricing strategy can be determined before the product enters production.
This may lead to better control of marketing and distribution costs.
 It also enables attention to be focused on reducing research and development
costs to get the product to the market as quickly as possible.
 By monitoring the actual performance of products against plans, lessons can
be learnt to improve the performance of future products and it may also be
possible to improve the estimating techniques.

NB. An understanding of the product life cycle can also assist management with decisions
about pricing, performance management and decision making.

Pricing
 As the product moves from one stage in its life cycle to the next ,a change in the
pricing strategy might be necessary to maintain market share for example as the
product enters maturity prices can be reduced.
 In addition, an understanding of the life cycle helps strategic decisions about the
price.
 Over the life cycle of the product, sales price should be sufficiently high to ensure
that a profit is made after taking into account start –up until withdrawal.

Performance Management
 As the product moves from one stage to the other, financial performance will change.
 Management should understand that an improvement or decline of performance could
be linked to the changes in the life cycle and therefore should act accordingly.

Decision making
 In addition to helping management with decisions on pricing and understanding life cycle
costing, it can also help with decisions about making investments in the product (new
capital investment expenditure)or withdrawing the product.
ACTIVITY BASED COSTING (ABC)
 It is a costing approach that analyses all activities to identify what drives costs
incurred that is what causes costs to increase.
 The major ideas behind ABC are:
 Activities cause costs—these activities include ordering materials, handling,
dispatching etc
 It believes that it is the products that create demand for the activities.
 Costs are assigned to products on the basis of the product’s consumption of
the activities.
NB In ABC:
 Some manufacturing costs may be excluded from product costs.
 Non manufacturing overheads as well as manufacturing costs may be assigned to
products.
 Overhead /activity rates are based on the activity level at capacity rather than on
budgeted levels. An activity is an event that causes the consumption of overhead
resources.
 A number of overhead cost pools, each allocated to products and other costing
methods /objects using its own unique measure of activity.

Cost driver
 This is a factor that directly influences cost over a relevant range of activity. This
could be number of orders, number of production runs, number of dispatches, labour
hours and machine hours.

Cost Pool
 This is a bucket in which costs are accumulated that relate to the single activities.

Reasons for the development of Activity Based Costing

 Activity Based Costing was developed to overcome the inability of absorption costing
to deal with the features of modern manufacturing methods.
 This was re –necessisted as a result of growth of overheads and the advent of advanced
manufacturing technology (AMT) that reduce the importance of labour.
  The traditional methods failed to take into account the increasing complexity of
modern manufacturing method.
 The modern approaches are characterized by:
 An increased amount of overheads as a proportion of total cost.
 An increase in the cost of service support functions which assist in the
manufacturing of a wide range of goods and services that are unaffected by
changes in production volume varying instead with the range and complexity
of the products.

Shortfalls of the Traditional Methods (Absorption)

 It implied that all overheads were related primarily into production volume.
 These were developed at time when organisations produced a narrow range of
overheads and these overheads formed a small fraction of total costs.
 The traditional approach tends to allocate too great a proportion of overheads to high
volume products and a too small proportion of overheads to low volume products.

Steps in Activity Based Costing

 Identify an organisation’s major activities.
 Identify the cost drivers for each major activity for example:
Activity cost driver
Ordering number of orders made
Material handling number of material movements
Production scheduling production runs
Dispatching number of dispatches etc
 Collect the cost associated with each activity into cost pools.
 Charge the activity cost to products on the basis of the number of activity depending
on the product’s demand for activities.

Example
Advantages
 ABC focuses attention on the real nature of cost behavior and hence helps in reducing
cost and identifying activities which do not add value to the product.
 More realistic as the product costs are provided and overhead cost traced to the
product.
 It is flexible enough to trace costs and processes, customer areas of responsibility as
well as product cost.
 Activity Based Costing recognizes the complexity and diversity of modern production
by use of multiple cost drivers many of which are transaction based rather than based
solely on production volumes.

Disadvantages
 The chosen cost driver may not be an adequate of the complexity of activities.
 The assumption of a direct linear relationship between the usage of a cost driver and
the amount of overheads can be untrue.
 ABC system is very complex due to numerous cost pools and cost drivers and hence it
can be expensive to operate.
Question 1

Practical exercises
Kanga Ltd. is a small but growing engineering group. Corporate guidelines indicate that no
new product should be introduced to the product range unless the anticipated rate of return
over the product lifecycle exceeds the company’s cost of capital.
Research and Development (R & D) staff at Kanga Ltd. recently carried out design work on
three proposed new products. Following consultation between R & D and marketing staff, the
following summary information is available

_ Direct labour hours per unit of output:

Product X Product Y Product Z
2 7 5
_ Production and sales quantities per month:
Product X Product Y Product Z
9,500 9,000 11,000
_ Total monthly overhead activity and costs in producing the three products:

Cost per month Level of cost driver

activity
Cutting operations $12500 2500 per month
Materials movements $9600 160 per month
Production set-ups $7200 15 per month

A target costing team established by Kanga Ltd. reviewed the data from the R & D staff. The
marketing staff warned that none of the three products will be adequately profitable, given
the expected market conditions and the cost of manufacturing the products using the
proposed design.
In an attempt to improve profitability, the target costing team subsequently worked with the
R & D staff to redesign Products Y and Z. The marketing staff confirmed that these design
modifications will have no effect on demand for the finished products. The reductions in
monthly activity levels as a result of these design changes are expected to be as follows:

Effect of design changes: Effect of design changes:

Product Y Product Z
Reduction in number of cutting operations 114 200
Reduction in number of materials movements 30 34
Reduction in number of production set-ups 2 1
It was found to be impossible to make any changes to the design of Product X.
REQUIRED:
(a) Assume that the proposed design changes will be implemented. Calculate the resulting
reduction in the unit cost of each of the company’s products in the following circumstances:
_ If all overheads are traced to products using activity-based costing.
_ If all overheads are allocated to products on a direct labour hour basis. (12 marks)

(b) Explain (using the example of Kanga Ltd. to illustrate your answer) why an activity based
costing system is essential for the implementation of target costing. (5 marks)
(c) A junior member of management at Kanga Ltd. has suggested that the company could
expand its product range more quickly by eliminating the requirement that no new product
should be introduced to the product range unless the anticipated rate of return over the
product lifecycle exceeds the company’s cost of capital. Comment on this suggestion. (3
marks)
[Total: 25 marks]

Question 2
Renco Ltd. manufactures a range of products, most of which have short product lifecycles.
Research and development staff recently designed three new products which would be
manufactured in a single production cell of the company’s factory. The combined monthly
manufacturing overhead costs of the three products are summarized as follows:

Production set-ups (10 per month) $2000

Materials movements (400 per month) $18000
Repairs (4000 per month) $30000
Total manufacturing overheads per month _50000
The following information is available concerning the three new products:
Product A Product B Product C
Production & sales, per month 2,000 units 5,000 units 1,000 units
Direct labour hours per unit 6 4 8

The company’s target costing task group expressed the view that the new products would not
be profitable given the likely market prices and the cost of manufacturing the products using
the proposed design. In response, the product designers indicated that no design changes
were possible in relation to Products A or B, but that changes in the design of Product C
would bring about the following reductions in the amount of monthly activity involved in
manufacturing that product without compromising either the quality or quantity of output:

Production set-ups Materials movements Repairs

2 per month 100 per month 1,000 per month
REQUIRED:
 (a) Calculate the reduction in the cost per unit of each of the three products which would
occur as a result of the design changes to Product C, in each of the following
circumstances:

If manufacturing overheads are traced to products using activity-based costing (ABC);

If manufacturing overheads are allocated to products on a direct labour hour basis.
(10 marks)

(b) Discuss the view that an ABC system is essential for the implementation of target costing.
Use the case of Renco Ltd. to illustrate your answer.
(5 marks)

Question 3

Mhuru Ltd. manufactures plastic components which it sells to three customers. These
customers are all manufacturing firms with which Mhuru has entered into long-term supply
agreements. Mhuru prides itself on its ability to quickly customize products to meet specific
customer requirements at short notice. In some cases the entire process of customizing and
manufacturing a product can be performed on a just-in-time (JIT) basis.

Prices are set in accordance with a cost-based formula. Costs of direct labour and raw
materials are traced to each customer, and marked up at rates of 60% and 70% respectively.
Production overhead is marked up by 50% and then allocated to customers in proportion to
direct labour cost. Because these markup percentages are slightly lower than those applied by
its competitors, Mhuru Ltd. has long believed that this pricing formula should enable it to
retain the loyalty of its three customers. The Marketing Director was therefore surprised
recently when he learned that one customer considered prices to be too high and was
seriously considering taking his business elsewhere.
Production overhead costs last month were made up of the following three elements:
Activity Driver Cost
Determining customer requirements Number of liaison meetings _8000
Making design changes Number of design changes _6000
Machine set-up Number of production batches _4000
Total = _18000
The following is a summary of the work carried out last month on behalf of the three
customers:
Customer A Customer B Customer C Total
Direct labour cost $ _2700 _5500 _3800 _12000
Raw material cost $ _3200 _5000 _2800 _11000
Number of liaison meetings 12 9 11 32
Number of design changes 13 15 22 50
Number of production batches 7 10 3 20

REQUIRED:
(a) Calculate the amount of profit which Mhuru Ltd. earned from each of its three customers
last month. (16 marks)
(b) Explain which customer is most likely to be unhappy with Mhuru’s pricing arrangements,
and recommend what steps Mhuru Ltd. should take in order to retain this customer.
(4 marks)
(c) Briefly explain how the implementation of a JIT approach to manufacturing can be a
major source of competitive advantage.
(5 marks)
[Total: 25 marks]
Activity Based Management
 Refers to the use of activity costing to improve management’s decisions to satisfy
customers and improve profitability.
 Areas include pricing and product mix decisions, cost reductions and business re-
engineering process.
 Development in ABC has shown a movement away from mere collection and analysis of
cost for management purposes to cost management systems whose characteristics are
:
 Determination of cost of resources used up on undertaking the organisation
‘major activities.
 The identification and elimination of activities which do not add value to the
organisation’s product and services.
 A critical analysis of efficiency and effectiveness of the activities carried out in
the organisation.
 Identification and evaluation of new activities which can prove the overall
profitability of the organisation.
THROUGHPUT ACCONTING
 It is the rate of conversion of raw materials and purchased components into products
sold to customers.

Constraints and Bottle necks in the system

 Throughput accounting originated from the theory of constraints (TOC) which is based
on the view that every system has a constrain (anything that limits our ability to
achieve what you want to achieve)
 If a system had no constraints, its output would be either zero or the system would
continue to produce more and more without any limits.
 Therefore for any system whose output is not zero, there must be a constraint that
stops it from producing more output than it does.

Reasons for Constraints

 External factors such as limits to customer demand on products produced by the
organisation.
 Weaknesses in the system s controls that is weak management.
 Weaknesses in the system such as shortages on key resources (materials) or capacity.
 In-a manufacturing system, constraints are referred to as bottlenecks. A bottle neck is
simply a constraint that limits the output of an organisation(material ,labour and
capacity)

Dealing with constraints

 Management of the business operations should focus on dealing with key constraints
by identifying what they are.
 Action by management to improve operational efficiency is a waste of time and
efforts if it is applied to any area of operations which is not a constraint.
 The key constraints limits through put since this could be a limitation in sales
demand, inefficiency production, unreliable suppliers or shortage of key resources of
production.
 Godraft developed the theory of constraints .He argued that :
1. Management should identify the key constraints and consider way of removing or easing the
constraint so the system is able to produce more output.
2. When one constraint is moved, another key constraint will take place so management must
be aware of that.
3. The new key constraint must be identified and management should now turn its attention
to way of reducing / removing its key constraint.
4. By removing constraints one by one, the output of the org will improve.

RELEVANCE OF TOC IN THROUGHPUT A/C

 Godratt argued that if the aim of the business is to make money and profit ,then the
appropriate method to do so are :
1. Increase the throughput
2. Reduce operating expenses
3. Reduce investment [money invested in inventory-can be reduced by reducing the level of
inventory] .
4.Godratt argued also that the most effective way of increasing profit is to increase
throughput and it can be increased by identifying bottlenecks and ease them .

THOUGHPUT ACCOUNTING

Assumptions
1. In traditional marginal costing it is assumed that direct labour cost are variable costs where
as in throughput it is termed a fixed cost since employees are paid on a continuous basis.
2. The only variable cost is the purchase of raw materials which comes from external
suppliers.
3. A business makes real profit by value addition.
4. Value added should be measured as the value of sales minus the variable cost of sales.

THROUGHPUT INVENTORY AND OPERATING EXPENSES

 Throughput accounting is based on these three (3) major items, that is, the
throughput itself, inventory and operating expenses.
 Therefore throughput is the rate at which the entity achieve its goal measured in
goal units :
 Thus throughput =sales –total variable cost (The variable cost is the sum of
materials and any other components.
NB. Throughput is only created when all inventories are sold
The Operating expenses
 These are the expenditures incurred to produce output and it consists of labour and
any other fixed cost incurred by the organisation.
 Therefore profit in throughput accounting is measured as:
Throughput –operating expenses
$
Sales xxx
Variable cost (material) ( xx)
Through put xxx
Less operating expenses (x)
Profit x

VALUE OF INVENTORY IN THROUGHPUT

 Inventories do not have value except the variable cost of the materials and
components.
 Work in progress and finished goods is only money invested that cost of purchase of
the raw materials is the value and nu value addition occurs until they are sold.
 Thus, in throughput accounting, all inventories are valued at the cost of raw materials
and components.
 The variable cost should not include the cost of labour as no value addition takes
place by producing but only when items are sold.

Example -Comparison of throughput and traditional costing

 A company produces 1000units of a product during the month of June and sells
800units for $32000. There was no opening inventory .Cost of production were as
follows:
$
Direct labour 8000
Raw materials 6000
Fixed production overheads 10 000
Other Non-production overheads 5000
Required
To calculate the profit of the period using:
a)absorption costing
b) Marginal costing
c) Throughput accounting
NB. Assume for the absorption that the budgeted and actual overheads were the same and
there are no under/over absorption of overheads.

Example

Solution
Comparison of costing methods
Absorption Marginal throughput
$ $ $
Sales 32 000 32 000 32 000
Less cost of production
Opening inventory - ------- ------ -------
Add production cost
Direct material cost 6000 6000 6000
Direct labour 8000 8000 -----
Prime cost 14000 14000 6000
Add fixed overheads 10000 ---- ---
Production cost 24000 14000 6000
Less closing inventory (200/1000*24000 4800 2800 1200
Cost of sales (19200) (11200) (4800)
Profit/contribution/throughput 12800 20800 27200
Less operating expenses
Other overheads (non production) (5000) (5000) (5000)
Fixed production overheads ---- (10000) (10000)
Direct labour ---- ---- (8000)
Profit 7800 5800 4200
Criticisms of throughput
 It concentrates on the short –term when a business has fixed supply of resources and
operating expenses that are largely fixed.
 It is more difficult to apply throughput accounting concepts to longer term when all
costs are variable and vary with the volume of production and sales or any other cost
driver.
 In the longer term ABC might be more appropriate for measuring and controlling
performance.

How to improve throughput accounting

 Increase sales price for each unit sold so as to increase throughput per unit.
 Reduce total operating expenses to reduce cost per assembly.
 Reduce material cost per unit by changing material or switching suppliers.
 Improve the productivity of the assembly workforce and reduce the time
required to make each unit of the product.
 Throughput per assembly hour would increase but the expenses per assembly
hour would be unchanged therefore the throughput would increase.

PERFORMANCE MEASUREMENT RATIOS IN THROUGHPUT ACCOUNTING

KEY PERFORMANCE MEASUREMENTS
*net profit – total throughput minus operating expenses

Major objective is to increase net profit

*return on investment
*throughput per unit of the bottleneck resource
*operating expenses per unit of the bottleneck resource
*throughput accounting ratio

*ROI (returns on investment)

- It is measured a net profit *100%
Investment
-the objective is to increase return on investment, either by increasing net profit or reducing
the size of the investment.

THROUGHPUT PRODUCTIVITY
Is measured as: throughput * 100%
Operating expenses

The major goal is to increase throughput productivity either by increasing throughput or

reducing operating expenses.

THROUGHPUT PER UNIT OF CONSTRAINT

The advantage is that labour is treated as a fixed cost. Thus in line in that where production
process has been automated, directed labour costs becomes less important to total
production costs. Unlike traditional approaches

THROUGHPUT ACCOUNTING RATIO

Is the ratio of (throughput in a period per unit of bottleneck resources to [operating expenses
per unit of bottleneck resource)

Thus throughput accounting ratio = throughput per hour of bottleneck resources

Operating expenses per hour of bottleneck resources

EXAMPLES
Makore investments manufacture window seals, each seal selling for $20. The materials costs
are $8 per unit. Total operating expenses each month are $12 000.
Machine capacity is the key constraint on production. There are only 600 machine hours
available each month and it takes three minutes of machine time to produce each unit.

Required
a) Calculate the throughput accounting ratio
b) How might the ratio be increased

Answers
a) Throughput per unit = ($20-8) = $ 12.
Throughput per machine hour = $12 (60m/3 minutes)

Calculated contribution throughput per hour = $240

 Operating expenses per machine hour = $12 000 = $200

600 hours

Throughput accounting ratio = 240 = 1.20

200

b) To increase the throughput accounting ratio, it might be possible to:

 Raise the selling price for window seals for each unit sold to increase the throughput
per unit.
 Improve the efficiency of machine time used and so manufacture units in less than 3
minutes.
 Find ways of reducing total operating expenses per machine hour.

THROUGHPUT ACCOUNTING AND DECISION MAKING

When a company can make more than one product, throughput per unit of constraint
factor can be used to rank products in order of priority for production.

Examples
Makudo investments manufactures a single product “chair “, for which the sales price is
$35.00 per unit and the material cost per unit is $7.50
Product “chair “is made in two consecutive production operations which are carried out in
Department f1 and f2. The capacity per month in each department is 6 400 hours

Conversion costs per week in each department are as follows:

Department f1
Department f2
Conversion costs per month $ 7 360 $3 200
Hours per month capacity 640 640
Conversion cost per hour $ 1.5 $ 0.50
 The company is operating at full capacity and it makes and sells 400 units of product “
chair “ each month .It has been offered an opportunity to make or sell 150 units of
product “ bench “ each month to a large customer or, who will pay $31.00 per unit. The
direct material cost per unit of product “bench “would be $ 15.00. Product “bench
“would be made in department f1 and f2 and the production time required per unit would
be as follows:

Product chair product

bench
Hours per unit hours per
unit
Department f1 16 12
Department f2 16 6

On the basis of “traditional costing “, the decision would be to reject the customer order
for 1 500 units of product bench per month, because product bench would appear to make
loss.
Product chair product bench
Direct materials 7.50 15.00
Conversion costs
F1 at $ 1.15 per hour 9.20 13.80
F2 at $ 0.50 per hour 8.00 3.00
Total costs per unit 24.70 31.80
Sales price 35.00 31.00
Profit/loss 10.30 (0.80)

However, this would be an incorrect decision if the goal is to maximize profit. There is
currently spare capacity in department f1, but time in department f2 is a key constraint.
Profit is maximized by maximizing throughput per hour worked in Department f2

Product chair product bench

$ $
Sales price 35.00 31.00
Direct material cost 7.50 15.00
Throughput per unit 27.50 16.00

Hours per unit in Department f2 16 6

Throughput per f2 hour $ 1.72 $ 2. 67

The optimal production plan is to make 150 units of product “bench “ per month, and use the
rest of the time to make units of product “chair”

ASSESSMENT OF CURRENT PRODUCTION PLAN “ CHAIR “

$
$
Total throughput (400 * 27.50) 11 000
Operating expenses
Department f1 7 360
Department f2 3 200
Total operating expenses 10 560
Net profit 440

The optimum production plan is to make 150 units of product bench, which would require (* 6
hours per unit) 900 hours per month. This would leave 5 500 hours of time in department f2 to
make product “chair “, this would be sufficient time for 5 500/16 hours per unit) 343 units
per month.

NB Making 150 units of bench and 343 of chair would require a total of 4 544 hours in
department f1 per month. Time in department f2 is therefore still the key constraint.
Optimal production plan 150 units of bench and 343 units of chair

Product bench: 150*16.00

2 400
Product chair: 343 * 27.50
9 433
Total throughput
11 833
Operating expenses
10 560
Net profit
1 273

 Net profit per month would increase by $ 833

LEARNING CURVES
 Most workers become more proficient at their task the more they do them.
 Learning takes place especially through the early stages of the job e.g contractors
constructing a high rise apartment building find the 20th storey that go on faster than
the 8th storey.
 The learning curve represents that the time spent per unit declines by a constant
percentage as the number of units produced doubles.
 The phenomenon has been observed where new long-term production activities are
undertaker / where a long production cycle is conducted such as building construction
projects, plan manufacture and ship building.
 Wright law: as cumulative output doubles, the cumulative average time per unit falls
to a fixed percentage [referred to as the learning rate] of the previous average time.

THE LEARNING RATE: CUMULATIVE AVERAGE TIME {C.A.T}

 In learning theory, the cumulative average time per unit produced is assumed to
decrease by a constant % every time total output of the product doubles.

EXAMPLES
 Where an 80% learning effect occurs, the cumulative average time required /unit is
reduced to 80% of the previous cumulative when output is doubling of output
produces a 20% decrease in C.A.T.

EXAMPLE 1 an 80% LEARNING CURVE.

 The first unit of a new product requires 100hrs .An 80% learning curve applies
.Production time would be :

1 2 3 4 5
Units Produced Total output Cumulative Total hours Average hours
average time [column 2x3] additional units
1 1 100 1x100=100 100
1 2 (0,8x100)=80 80x2=160 160-100=60
2 4 (0,8x80)=64 64x4=256 256-160=96
4 8 (0,8x64)=51,2 51,2x8=409,6 409,6-256=153,6
8 16 0,8x51,2=40,96 40,96x16=655,36 655,36-
409,6=245,7

100
60 - for extra 1
48 (96#2) for extra 2

 Learning curves are also used to estimate price to be quoted on customer’s orders
.The learning curve effect means that a company can afford to charge less per unit
for greater quantities.

Exercise
Angwa Ltd has been requested to supply 8 units of a new product to the customer’s
specification .The estimated labour time for the first unit is 25hrs and the labour cost is
$10/hr.
a. Calculate the labour cost for the order.
B.Calculate the labour cost of a second order with the same quantity (8 units).

SOLUTION

Units Produced Total output Cum Average time Total Average Ave. hours
1 1 25 25x1=25 25
1 2 (0,9x25)=22,5 22,5x2=45 45-25=20
2 4 (0,9x22,5)=20,25 20,25x4=81 81-45=36
4 8 (0,9x20,25)=18,225 18,225x8=145,8 145,8-81=64,8
8 16 (0,9x18,225)=16,4025 16,4025x16=26244

a) Total labour cost for 8 units 145,8hx$10/h

=$1458
b) 2nd order =(262,44x$10)-$1455
 =$1166, 4

EXAMPLE 2
A company wishes to determine the price it should charge a customer for a special
order .The customer has requested a quotation for 10machines but might subsequently
place another order for a further 10 .Material costs are $30 per machine. It is
estimated that the first batch of 10 machines will take 100hours to manufacture and
an 80% learning curve is expected to apply. Labour plus variable overhead costs
amount to $3 per hour. Set -up costs are $1000 regardless of the number of machines
made.

a) What is the minimum price the company should quote for the initial order if there
is no guarantee of further orders?
b) That is the minimum price for the following order?
c) What would be the minimum price if both orders were placed together?
d) Having completed the initial orders for the a total of 20 machines (price at the
minimum levels recommended in (a)and (b) the company thinks that there would
be a ready market for this type of machine if its unit selling price is brought to
$45.
e) At this price, what would be the profit on the first (1) 140 mass production models
(that is after the first 20 machines) assuming that marketing costs totaled $250?

Solution

Initial order
Materials [10 * $30] 300
Labour and variable overhead [100 * $3] 300
Set-up cost 1000
Total 1600
Minimum price 1600:10 =$ 160
Second batch
Units produced Total output C. A. T Total hours Average hours

1 1 100 100*1=100 100

1 2 (0,8 * 100)=80 80*2 =160 160-100=60

Material [10*$30] 300

Labour + variables [60*$3] 180
Total cost 480
Minimum price [480:10] 48

Both orders Together

Material [20*$30] 600
Labour [160hrs * $3] 480
Set-up cost 1 000
Total cost 2 080
Minimum price [2 080: 20] 104

Mass Production
Total produced =20 machines + 140 machines = 160 machines or 16 batches.

y = a + b where a= time taken to produce first machine batch

x= cumulative total number of units produced per batch
a= log r/log 2 [lob r =learning curve %

Average time for first 2batches
Total time for first 2 batches
Average time for first 16 batches
Total time for first 16 batches
Hence time for batches 3 to 16
= 100 * 2 (-0, 321928) =80 hrs
= 80 * 2 =160hrs
=100 * 16 (_0, 321928) =40,96hrs
= 40, 96 * 16 = 655, 36 hrs
=655, 36 – 160 = 495, 36 hrs

Cost for first 140 mass production machines

Material [140 * $30] 4 200
Labour + Overhead [495, 36 * $3] 1 486
Marketing 250
Total 5 936

Calculation of profit
Revenue [140 * $45] 6 300
Less Total cost 5 936
Profit 364

The learning curve and the steady curve

The learning effect will only apply for a certain range of production. Once the steady state is
reached, the direct labour hours will not reduce any further and this will become the basis on
which the budget is produced.
LAMINATION OF THE LEARNING CURVE MODEL
The learning, whilst being an important factor to be taken into account, if it exists, is based
on specific assumptions which may or may not apply in a modern manufacturing environment.
The model applies if the process is;
 labour intensive
 No breaks in production.
 a new product being developed
 complex
 repetitive
It may also be difficult to identify the learning curve effect in practice

The learning curve can be expressed in a form of an equation as;

y= a * b

Where y = cumulative average time per unit (C. A. T)

x = cumulative total number of units produced
a = time taken to produce the first unit
b = index of learning [-0, 3219 for a Lc of 80%

The method can be used to calculate y values for the data straight away.
TRANSFER PRICING

 In divisionalised companies, where profit or investment centers are created,

interdivisional transfers of goods or services and this internal transfer create the
problem of pricing.
 A satisfactory system of transfer pricing is necessary for measuring the performance of
transfer divisions.
 A transfer price is that national value at which goods and services are transferred
between divisions in decentralized organisations.
 Transfer prices are set for intermediate products which are goods and services that
are supplied by the selling division to the buying division.

Objective of transfer pricing

 Transfer pricing should help in the accurate measurement of divisional performance
(profitability) measurement.

Transfer pricing when outside suppliers are available

 Selling division below capacity

 Using information above , Disc Tech LTD , the IT division buys from an outside supplier
,the facilities that hardware division uses to manufacture the units would remain idle
 The general economic transfer pricing rule when the seller is operating below capacity
(an idle capacity ) states that the seller should set the transfer price at variable cost
per unit

EXAMPLE 2
Inscor LTD owns fast food restaurant and snack food and beverage manufacturing in
Zimbabwe. One of the restaurant Pizza Inn serves a variety of beverages along with pizzas.
One of the beverages is ginger beer which is served on tap.
The MD of Imperial beverage has approached the MD of Pizza Inn about purchasing imperial
beverage’s ginger beer for sale to Pizza Inn restaurants rather than its usual brand of
ginger beer. Manager at Pizza Inn agreed that the quality of their regular brand is ok; it was
just a question of price. The basic facts for the divisions were as follows:
IMPERIAL B

 A ginger beer production per month --- 10 000 barrels

 Variable cost per barrel --- $8
 Fixed cost per month --- $70 000
 Selling price of Imperial beverage ginger beer on outside market is $20 per barrel.

PIZZA INN
 Purchase price of regular brand of ginger beer --- $18 per barrel
 Monthly consumption of ginger beer --- 2000 barrels

Calculate
a) The selling division’s lowest acceptance transfer price.

NB. Imperial will transfer internally if their profit increases as such the transfer price cannot
be below $8. In addition if Imperial has insufficient capacity to fulfill the Pizza Inn order then
it will give up some of its regular sales and as such need compensation for lost contribution
margin on lost sales. If the transfer price has no effect on fixed costs from the selling
divisions ‘s stand point ,the transfer price must cover both the variable cost of producing the
transferred units and only opportunity cost from lost sales.

Seller’s point of view

 Transfer price greater than or equal to variable cost /unit + total contribution
Margin on sales (lost)
Number of units transferred
Purchasing Department

TP < outside supplier’s price

 The purchasing determent PIZZA INN will be interested in the proposal only if its
profits increase. In cases where the division has an outside supplier purchasing
 decision is simple-buy only from the inside supplier if the price is < the price offered
by outside suppliers

a. Selling divisions with idle capacity

Imperial beverages is selling 7000 barrels of ginger-beer a month on the outside market
.What would be the transfer price if any would make things better off with the transfer of
2000 barrels

TP = variable cost + total contribution margin on cost sales

Number of units
= 8 + 0
2000
= $8
Purchaser < 18

selling division with the no idle capacity

 Imperial has no idle capacity and is selling 10 000 barrels a month to an outside
market at $20.What range of transfer pricing would make both divisions better off
transferring 2000 barrels within the company.

TP > 8 + [selling price – variable cost] lost sales

20 - 8 (2000)
2000
> 8 + 12

> 20
Purchaser TP > 18
I. Therefore in this case , no transfer price taken place as it result in loss to the
organization
II. Selling division with no idle capacity
III. Selling division with some idle capacity
Imperial beverage is selling 9000 barrels to its regular customers a month. Pizza Inn can only
sale one type of ginger beer on tape .What range of transfer if any would make both divisions
better off transferring within the company

PT > 8 + 20 - 8 (1000)
2000

> 8 + 6
> $14

Transfer price is possible as it is acceptable within the range.

Transfer price where there are no outside supplier .If Pizza Inn has no outside supplier the
highest price the purchasing departmant will be to buy depends on how the purchasing
division expect to make on transfer units excluding price .

Transfer cost

Variable cost $8
Full cost $15 [8 + 70 000
10 000

 No profit for selling division and profit can be shown by buying division when they sell
to outside customers
 Cost price do not provide incentives to control costs and will affect goal congruence

Transferring at market price

Market price is a price charged on intermediate market

Intermediate market is a market on which a transfer product or service is sold is sold
its present form to outsiders
Its only effective when there is no idle capacity

Transfer price in international market

 Objective of transfer pricing in international market

To pay less taxes , duties and tariffs

Meant to ensure that there are
To ensure better competitive position
To align with government regulation

Practical exercises
Nhongo Ltd. is a divisionalised company. Each month the company’s Chemicals Division
manufactures 6000 tons of a product which it sells to external customers at a price of _$200
per ton. The fixed costs of the Chemicals Division are _$288 000 per month and the marginal
costs of production and sale amount to $90 per ton. An absorption costing system is used to
work out a ‘full cost per ton’ on the basis of this level of cost and activity.

Another division of the company (the Detergents Division) buys 2000 tons of a very similar
chemical from an external supplier each month at a price of _$150 per ton. However, the
Chemicals Division has sufficient spare capacity to enable it to supply the monthly needs of
the Detergents Division. The transfer price which the Chemicals Division would charge would
be the ‘full cost per ton’ as calculated on the basis of the increased level of output. The
Detergents Division has indicated that this transfer price would be acceptable.

REQUIRED:
(a) Calculate the transfer price proposed by the Chemicals Division, and show that this
transfers pricing arrangement will motivate both divisions to act in a manner which is in the
best interests of Nhongo Ltd. as a whole.
(7 marks)

(b) Assume now that the two divisions cannot agree on transfer pricing arrangements for the
2000 tons. Specifically, the Chemicals Division will not accept any price lower than _$145 per
ton but the Detergents Division will not agree to pay any price higher than $95 per ton.

Discuss whether, in these circumstances, the board of directors of Nhongo Ltd. should
intervene to order the divisions to make the transfer at the price calculated in your answer to
part (a). (9 marks)
(c) Assume now that the Detergents Division requires a further 500 tons per month (in
addition to the 2000 tons), but that the Chemicals Division has no additional spare capacity
and therefore these 500 tons could only be provided to the Detergents Division if the
Chemicals Division were to reduce sales to its external customers by an equivalent amount.

Assume also that the marginal cost to the Chemicals Division of supplying a ton to the
Detergents Division is $3 lower than the cost of supplying a ton to an external customer.
What is the appropriate transfer price per ton for these 500 tons? Explain your answer.
(4 marks)
[Total: 25 marks]

Question 2

Mangwiro Ltd. manufactures advanced technical components for the computer hardware
industry. The company’s Uhuru Division manufactures a special subcomponent at a variable
cost of $70 per unit. This division’s maximum monthly production capacity is 2700 units, but
its actual production each month is 2500 units. Of this actual monthly production, 1500 units
are sold to external customers (at a price of $100 each) while the remaining 1000 units are
transferred to the company’s Chopa Division at the same price.

The Chopa Divisions’ maximum production capacity is 1350 units per month. However, market
demand for the division’s product is only 1000 units and therefore production is carried out at
this level. In producing one unit of its product, Chopa Division uses one unit of the
subcomponent purchased from Uhuru Division and incurs additional variable costs of $90 per
unit. The selling price of Chopa Division’s product is $200 per unit.
The Chopa Division recently received an enquiry from a new customer, who has offered to
purchase 300 units of that division’s product each month at a price of $185 per unit.

REQUIREMENT:

(a) Prepare calculations to indicate the increase in the monthly profits of Mangwiro Ltd., if
the new customer’s offer is accepted.
(7 marks)

(b) Prepare calculations to indicate whether the existing transfer pricing arrangements would
motivate each of the two divisions to cooperate in transferring the 300 subcomponents
needed in order to manufacture the new customer’s order.
(6 marks)

(c) Identify the minimum transfer prices which would be acceptable to Uhuru Division and
identify the maximum transfer prices which would be acceptable to Chopa Division. Then,
suggest a transfer price per unit for the 300 subcomponents which would achieve the
following:

_ the incremental profits from doing business with the new customer are to be shared equally
between the two divisions.
_ The same transfer price per unit is to apply to all units transferred.
(7 marks)

Question 3
Rungano Ltd. manufactures a wide range of specialized electrical products. The company is
structured along divisional lines.
“Division X” manufactures a specialized motor. Monthly production is 3000 units and the
marginal cost of production is _$140 per unit. Half of all output is sold to external customers
at a price of _$200 per unit. The remaining output is sold within Rungano Ltd. to “Division Y”.
In accordance with the company’s rules, these internal transfers are made at the same price
per unit as sales to external customers (i.e. $_200).
“Division Y” uses the motor as a component in the manufacture of an industrial heater, which
is sold to external customers at a price of _$350 per unit. (One motor is required for each
heater). “Division Y” incurs a marginal cost of $_100 per unit, in addition to the transfer price
paid for the motor.
A potential new customer (Kwangu Ltd.) has offered to purchase 750 units per month of the
industrial heater from “Division y” at a special contract price of $275 each. “Division Y” has
sufficient spare production capacity to produce these additional heaters.
REQUIRED:
(a) Assume that “Division X” has sufficient spare production capacity to enable it to produce
the additional motors required by “Division Y” to enable it to fulfill the Kwangu Ltd. contract.
In these circumstances, explain:
_ Whether it would be in the best interests of Rungano Ltd. to accept the Kwangu Ltd.
contract, and
_ whether the existing transfer pricing arrangements motivate the division managers to take
the decisions which are in the best interests of Rungano Ltd. as a whole.
(10 marks)
(b) Now assume that “Division X” has no spare production capacity. If “Division X” were to
produce the additional motors required by “Division Y” to enable it to fulfill the Kwangu Ltd.
contract, then “Division X” would reduce its sales of motors to external customers.
Explain how your answer to part (a) would differ in these circumstances.
(7 marks)
(c) Critically evaluate the transfer pricing arrangements in Rungano Ltd., using your answers
to parts (a) and (b) to illustrate your answer.
(8marks)

(Total 25marks)

Bamaco Company is a company specializing in the manufacturer and sale of kitchen sink.
Each sink consist of a main unit plus a set of kitchen fittings. The company is split into two
divisions C and D. Division C manufactures the sink and Division D manufactures set of kitchen
fittings. Currently, all of Division C’s sales are made externally. Division D, however, sells to
Division C as well as to external customers. Both of the divisions are profit centres.

The following data is available for both divisions.

Division C

Current selling price for each sink $450.00

Cost per sink

Fittings from Division C $75.00

Other materials from external suppliers $200.00

Labour costs $45.00

Annual fixed overheads $7 440 000

Annual production on sales of sink (units) 80 000

Maximum annual market demand for sink (units) 80 000

Division C

Current external selling price per set of fittings $80

Current price for sales to Division A $75

Costs per set of fittings:

Materials $5

Labour costs $15

Annual fixed overheads $4 400 000

Maximum annual production on sales of set of fitting (units) (including 200 000
Internal and External sales)

Maximum annual external demand for sets of Fittings (units) 180 000

Maximum annual internal demand for sets of fittings (units) 80 000

The transfer price charged by Division D to Division C was negotiated some years ago between
the previous divisional managers, who have now both been replaced by new managers. Head
Office only allows Division C to purchase its fittings from Division D, although the new
manager of Division C believes that he could obtains fittings of the same quality and
appearance for $65 per set. If he was given autonomy to purchase from outside the company.
Division D makes no cost savings from supplying internally to Division C rather than selling
externally.

Required
1. Under the current transfer pricing system, prepare a profit statement showing the
profit for each of the divisions and for Bamco Company as whole. Your sales and costs
figures should be split into external sales and inter-divisional transfers, where
appropriate. [6 marks].

2. Head office is considering changing the transfer pricing policy to ensure maximization
of company profits without demotivating either of the divisional managers. Division C
will be given autonomy to buy from external suppliers and Division D to supply
external customers in priority to supplying to Division C. [6 marks]

Calculate the maximum profit that could be earned by Bamco Company if transfer pricing is
optimized.[8 marks]

3. Discuss the issues of encouraging divisional managers to take decisions in the interest
of the company as a whole, where transfer pricing is used. Provide a reasoned
recommendation of a policy Bamco Company should adopt. [6 marks]

DIVISIONAL PERFOMANCE

Management should know what they expect to achieve and they should also be in the
goal-setting process. Failure results in dys function behavior which conflicts with the
short term interest of the organisation.
Thus, managers should know what they are achieving; this should involve the setting
up and maintenance of a well co-ordinate information system.
Managers should be provided with a measure of performance which is constant with
their responsibilities and they should not be held accountable for the actions and
course which are outside their control.

TYPES OF SEGMENTS \ BUDGET CENTERS THAT CAN BE CREATED

1. Cost centre
In this unit , the manager has authority to control amount of expenses incurred but has
no authority to change the resource investment
 In this centre , fin performance is measured by whether the assigned task is completed
within the budgeted cost levels
Managers of cost centers are expected to minimize cost while providing the level of
service or amounts of products demanded by other parts of the organisation. For
example ,the manager of a product center will be evaluated at least in part by
comparing actual cost as to how much should have been the actual cost for the units
provided [flexed costs] for the period.

2. Revenue centre
In this centre , performance is measured by whether the unit achieves budgeted
levels of sales revenue
The issue of expenses incurred in generating revenue is not the responsibility of a
revenue center management
Zimra is atypical Zimbabwe revenue center

3. Profit center
IN this centre , financial performance is measured whether the unit has achieved its
budgeted profit
A profit centre manager is therefore responsible for the sales revenue and expenses
but his major aim is to promote the profit motive throughout the organisation
In addition to the selling price based on normal arms length transaction with 3rd
parties ,transfer prices have to be negotiated for intercompany sales of goods and
services
Where negotiations are made, revenues of one department or division will constitute
cost of another.
CUT marketing department may be a profit center

4. Investment centre
In this centre , financial performance is measured by whether the actual return on
investment is equal to or exceed the budgeted return
In addition to controlling sales revenue and cost , an investment centre manager is
responsible for capital investment decisions and is able to influence the size of
investment
 Investment center managers are encouraged to plan, control and make decisions for
the cost, revenue and investment entrusted in them.
The investment centre managers who have details of knowledge of local customers
and economic conditions can use that knowledge to the advantage of their division and
ultimately to the company as a whole
NB An investment centre manager does not however enjoy total control over the level of
investment as he has to compete with other divisions for the scarce resources whose
disbursement may be controlled by head office

MEASURE OF PERFORMANCE IN DIVISINALISED

The rate of return for measuring managerial performance

Managers are given autonomy that the various profit and investment centers are
taken as independent businesses with their managers having about the same
control over divisions as if they where running their own independent firms
With autonomy , fierce completion developments among managers with each
striving to make his segment the best in the company

KEY QUSTION
How do top managers at headquarters go about deciding who gets new investing
funds as soon as they become available and how do these managers in the centres
decide which investment funds

Headquarter managers may use rate of return on investment [ ROI ]

The return of Investment

Defined as net operating income divided by average operating assets.

The higher the ROI of a business segment, the greater the profits generated
per dollar invested in the segment’s operating assets.
Net operating income is profit before interest and tax , popularly known as
EBIT
 Operating assets include cash and cash equivalent, trade receivables, PPE,
non-current assets and all other assets held for productive us in the
organization
Excluded are assets such as land held for future development of investment
held in other companies
Thus average operating assets is assets at the beginning and those at end

MATOR CHALLENGER

 Non-current assets debate is on what base to us cost or NBV of the assets

 Other advocate prefers net book value and other advocators prefer cost
 In calculating ,both approaches were used but yield different figure

ADVOCATES FOR NBV

 They say NBV is consisted with how PPE[property plant and equipment] are reported
on statement of financial position[SOFP]
 NBV is also consistent with the computation of operating income which includes
depreciation as an operating cost

ADVOCATE FOR COST

 The cost method eliminates both the age of equipment since the method of
depreciating used is factors in depreciating which is used in the computation of
operating income.
 Under NBV ,ROI ,tends to increase overtime as book value of assets decline due to
depreciation

 Cost method does not discourage replacement of old worn out equipment.

 However, due to the need of maintaining consistency, most companies use book value.

CONTROLLING RATE OF RETURN

 ROI = O. I
A.O, A
 This can be modified to ROI = operating income(margin) * 100 * Turnover
Turnover or sales 1 A.O.A

 Margin is the measure of management’s ability to control operating expenses per

dollar of sale, the higher he margin.
 Turnover is the measure of sales that is generated for each dollar invested in
operating assets.
 So ROI using turnover and margin is calculated as:

ROI = MARGIN * TURNOVER

 To this end, which formula now to use as both gives the same answer?
 The second one gives better insights about the organisation
 ROI forces managers to control the investment in operating assets as well as to control
the expenses and hence the margin.
 The DUPONT pioneered the ROI concept and recognized the importance of looking at
both margin and turnover in assessing performance of a manager.
 The investment manager can control the ROI in 3[three] ways;
1. Increase sales
2. Reduce expenses
3. Reduce assets

EXAMPLE

ABC LTD presence the following data which represents results of operations for the
most recent month:

Net Operating Income 10 000

 Sales/Turnover 100 000
Available Operating Assets 50 000

Calculate ROI in terms of margin and turnover.

SOLUTION

R. O. I = operating income * 100 * turnover sales

Turnover/ sales 1 A. O. A

= 10 000 * 100 * 10 000

100 000 1 50 000

= 20%

INCREASE IN SALES

 If the manager increases sales from $100 000 to $110 000 with other costs
remaining constant as well as the assets. What is the new R.OI?

= 20 * 10 000

100

= $2 000

For every $10 000 increase in sales, the profit will increase by $2000

R. 0. I = 12 000 * 100 * 110 000

110 000 1 50 000

= 24%
REDUCE THE EXPENSES
 Assume that the manager of ABC LTD reduces expenses by $1000, what is the
new R. O.I if sales and operating income remain constant

New operating income = $11 000 [10 000 + 1000]

R. O. I = 11 000 * 100 * 100 000

100 000 1 50 000

= 22%

REDUCE ASSETS

Assume the manager can reduce assets from 50 000 to 40 000, sales and net operating income
remain unchanged, what is the new R. O. I?
R. O. I = 10 000 * 100 * 100 000
100 000 1 40 000

= 25%
A clear understanding of the 3(three) approaches to improving R O I figure is critical to
effective management of an investment centre.

OTHER MEASURES OF PERFOMANCE

1. RESUDUAL INCOME
 This refers to controllable contribution less cost of capital charge.
 For divisional purpose, residual income can be defined as divisional
contribution less cost of capital charge on total investment in assets employed
by the division.
 It enables managers when acting in their own best interest also to act in the
best interest of the organisation.
 A company has two divisions, x and y .Proposed investments in the two
divisions were packed at $10 000 each for which 5he controllable contribution
 of x $2 000 and y is $1 300. What is the residual income if cost of capital
charged is 15%?

SOLUTION

Residual income =Controllable contribution - Cost of capital charge

x = 2000 - 1 500
= 500

Y = 1 300 - 1 500
= (200)

ECONCMIC VALUE ADDED [ EVA ]

 Economic profit is wealth created above the capital cost of investment.

 EVA prevents managers from thinking that the cost of capital is free
 It is therefore a measure of a company’s financial profit based on operating
profits[adjusted for taxes on a cash bases]
 Therefore EVA = net 0perating profit after tax[NOPAT] – The cost of capital
charge.[cost of capital being the capital - cost of capital]
 It therefore measures whether operating profit is sufficient enough to cover the cost
of capital.
 If EVA is negative, it means the firm is destroying the share holder’s wealth.
 EVA means real profitability.EVA focuses managers on the question, “for any given
investment, will the company generate returns above the cost of capital.
 Companies that use EVA have bonus compensation skills in place that reward/ punish
managers for adding/ subtracting value for the company

Practice exercises
Geddes Pharmaceuticals is a division of CAPS which was formed by acquiring a previously
independent company (“Harare P”) in February 2011. The budgetary control system used in
this division has remained largely unchanged since Harare P was acquired, including a form of
strategic planning and control which involves the comparison on a monthly basis (against
budgets) of three aggregate-level performance measures, namely:
• Economic value added ™ (EVA);
• Residual income (RI);
• Return on investment (ROI), restated to its annual equivalent (e.g., if ROI for a given month
is 1% then this is restated as 1 * 12 months = 12% annual equivalent ROI).

The following is the forecast of these three measures for the next six months:
Sept Oct Nov Dec Jan Feb
EVA 850 620 950 1,170 730 500
RI 750 700 1,000 1,100 700 700
Annual equivalent ROI 9.6% 9.2% 10.6% 11.1% 9.5% 9.7%

REQUIRED:
Prepare a report for the Group Executive in which you critically assess this approach to
budgetary control, and suggest options as to how the current approach to strategic planning
and control should be improved.
(13 marks)

Suggested solution

To: Group Executive

From: Trainee accountant
Date: 31/12/2011

Re: Assessment of Geddes Pharmaceutical’s budgetary control system.

Please find enclosed a report with a critical assessment of Geddes Pharmaceutical’s
budgetary control system and suggestions for improvement.

I will be pleased to provide any clarification that you may require.

Yours Sincerely
Trainee Accountant

Assessment of current system:

The existing system is unnecessarily complex in the sense that it uses multiple measures of
what are (to a large extent) the same underlying phenomenon’s. In particular, it is evident
from the data that there is a very strong correlation between
ROI and RI, and this is because they are simply different ways of capturing the same two basic
pieces of information (operating profit and capital invested).

Admittedly the correlation between ROI and RI is not “perfect”, e.g., RI is exactly the same
in October, January and February whereas ROI differs slightly between these months.
However, this is essentially a technical difference (RI factors cost of capital into the
calculation, whereas in an ROI assessment the cost of capital acts as the benchmark). The
point remains that there is no strategic advantage in trying to manage with both of these
variables.

Suggestion for improvement:

EVA does have “extra” information content, not captured by ROI or RI. For example, a more
“cyclical” trend is evident in the EVA data than in the RI data. This is due to adjustments to
the income or asset measures used in calculating EVA to make the measure “economically
meaningful”, such as the capitalization and amortization of intangible assets. For example,
scrutiny of the data seems to suggest that this has depressed EVA in February.
In essence, EVA is a more economically meaningful version of RI, and in this sense EVA may be
preferred to RI as the financial performance measure to be used for strategic planning and
control. However, EVA is necessarily more subjective.

It does not seem appropriate to use both RI and EVA in a budgetary control system because
their information content has many fundamental similarities, some differences
notwithstanding. Irrespective of the performance measure, the use of a monthly basis of
budgetary control is inappropriate at the strategic level. The success (or otherwise) of a
strategic investment can really only be assessed over its whole lifecycle, e.g., there may be
an initial costly investment in market research or branding without any expectation of
financial return until much later. At the very least, measures such as those already in use are
typically applied on an annual basis because monthly assessment is at best meaningless and
can at worst encourage dysfunctional behavior.
More fundamentally, the use of measures such as ROI and RI (at any fixed time interval) to
represent degrees of strategic success is questionable. It is appropriate that a strategic target
be broken down into manageable goals which can be tracked and measured in the short term;
often in ways that are nonfinancial (e.g., rates of consumer awareness of a new product). If
ROI or RI is used as “the” performance measure, then they become ends in themselves

Tapera PLC, a large multinational company, is undertaking a review of its organizational

structure. Top management is concerned that the methods used for divisional performance
evaluation and transfer pricing may be encouraging dysfunctional behavior by division
managers.
The following sample data is available concerning two of the company’s divisions for last
year:
Division X Division Y
Operating profit $15200 $7200
Capital invested $160000 $57600
The cost of capital is 7% for both divisions. It can be assumed that there are no intra-company
transfers between Divisions X and Y.

REQUIRED:
(a) Calculate the Return on Investment (ROI) and residual income for each division. Explain
which of these two measures (ROI or residual income) gives the clearer indication of divisional
contribution to the overall success of Tapera PLC.
(8 marks)
(b) Assume that ROI is used for divisional performance evaluation purposes. How would each
of the two division managers react to an additional investment opportunity which would
increase operating profit by $2300 but would require capital investment of $22000? Are their
reactions in the best interests of the company’s shareholders? Justify your answer. (8 marks)
(c) At what cost of capital would the two divisions have the same residual income? (In
answering this part, ignore the additional investment opportunity in part (b) above). (4
marks)

(d) Although there are no intra-company transfers between Divisions X and Y, there are a
significant number of intercompany transfers between other divisions of Tapera PLC. Discuss
the circumstances in which it is feasible and appropriate to use external market prices as the
basis for setting transfer prices in such cases. (5 marks)

[Total: 25 marks]

Fanago Manufacturing PLC is a divisionalised company. Maguire is the manager of the

Company’s Textiles Division and he is considering the introduction of a new product line. This
would require an immediate investment of $100000 in new fixed assets plus $50000 in
additional working capital.
The fixed assets would have a useful life of four years, and the product line would be
discontinued at the end of that time.
During each of the four years, 15000 units of the product would be produced and sold at a
price of $18 each. Variable costs of production would be $12 per unit and fixed costs (other
than depreciation) would amount to $50000 per annum. It is believed that a cash sum of
$20000 would be received when the fixed assets are sold for scrap at the end of their four
year life. However, in accordance with the company’s standard accounting practices, the full
purchase cost of the fixed assets would be depreciated on a straight-line basis over their
useful life (i.e. a zero residual value would be assumed in the calculation of the annual
depreciation charge). The working capital investment would be recovered in full at the end of
the projects life.

The performance of the Textiles Division is measured each year on the basis of Return on
Investment (ROI).
For this purpose, profit is defined to include any gains or losses on fixed asset disposals and
the investment base is defined as working capital investment plus the net book value of fixed
assets at the beginning of the year.
Maguire is paid a bonus each year which is linked to the extent by which his divisions actual
ROI exceeds the divisions required (or target) ROI. The required rate of return for the Textiles
Division is 10% per annum, and this is also the divisions cost of capital. Maguire’s own
financial forecasts indicate that (in the absence of the proposed investment in the new
product line) the Textiles Division will earn a ROI of 15% per annum for the next five years.
Maquire plans to leave his current employment within the next two to three years and set up
in business as a consultant to manufacturing companies who could benefit from his
experience and advice.

REQUIREMENT:
(a) Calculate the ROI of the proposed investment in each of the next four years. Then,
explain whether or not Maguire is likely to accept this proposed investment, assuming that he
acts to maximize his own self interest.
(10 marks)

(b) Calculate the net present value of the proposed investment.

(4 marks)

(c) The use of ROI as a performance measure does not necessarily ensure that a division
manager will take decisions which are in shareholders best interests. Give three examples of
why this so, using the case of Fanago Manufacturing PLC to illustrate.
(6 marks)
[Total: 20 marks]
BUDGETING

 A BUDGET is a formal statement of a company’s future plans.

 It is expressed in monetary terms because the economic and financial aspects of the
business are the primary factors driving management’s decisions.
 All managers should be involved in budgeting.

PURPOSE AND USES OF BUDGETS

1. Planning annual operations.

 Annual budgeting process leads to the refinement of previous plans since managers
must produce detailed plans for the implementation.
 Ensure that manager’s plan for future operations and that they consider how
conditions in the next year might change and what step they should take now to
respond to these changes.
 These processes encourage managers to anticipate problems before they arise and
hasty decisions that are made on the spur of the moment, based on expedients rather
than reasoned judgment will be minimized.

2. COORDINATION PURPOSES
The budget serves as a vehicle through which actions of different parts of an organization
Nhongo Ltd. is a divisionalised company. Each month the company’s Chemicals Division
manufactures 6000 tons of a product which it sells to external customers at a price of _$200
per ton. The fixed costs of the Chemicals Division are _$288 000 per month and the marginal
costs of production and sale amount to $90 per ton. An absorption costing system is used to
work out a ‘full cost per ton’ on the basis of this level of cost and activity.
Another division of the company (the Detergents Division) buys 2000 tons of a very similar
chemical from an external supplier each month at a price of _$150 per ton. However, the
Chemicals Division has sufficient spare capacity to enable it to supply the monthly needs of
the Detergents Division. The transfer price which the Chemicals Division would charge would
be the ‘full cost per ton’ as calculated on the basis of the increased level of output. The
Detergents Division has indicated that this transfer price would be acceptable.

REQUIRED:
(a) Calculate the transfer price proposed by the Chemicals Division, and show that this
transfers pricing arrangement will motivate both divisions to act in a manner which is in the
best interests of Nhongo Ltd. as a whole.
(7 marks)

(b) Assume now that the two divisions cannot agree on transfer pricing arrangements for the
2000 tons. Specifically, the Chemicals Division will not accept any price lower than _$145 per
ton but the Detergents Division will not agree to pay any price higher than $95 per ton.

Discuss whether, in these circumstances, the board of directors of Nhongo Ltd. should
intervene to order the divisions to make the transfer at the price calculated in your answer to
part (a). (9 marks)

(c) Assume now that the Detergents Division requires a further 500 tons per month (in
addition to the 2000 tons), but that the Chemicals Division has no additional spare capacity
and therefore these 500 tons could only be provided to the Detergents Division if the
Chemicals Division were to reduce sales to its external customers by an equivalent amount.

Assume also that the marginal cost to the Chemicals Division of supplying a ton to the
Detergents Division is $3 lower than the cost of supplying a ton to an external customer.
What is the appropriate transfer price per ton for these 500 tons? Explain your answer.
(4 marks)
[Total: 25 marks]

 Can be brought together and be reconciled into a common plan.

Budgeting compares managers to examine the relationship between their co-operation
and those of other departments and in the process, identify and resolve conflicts.

3. IT ENHANCES COMMUNICATION
 Budgeting ensures that the definite terms of communication are laid down so that all
parts of the organization will be kept fully informed of the plans and policies which
the organization expects to achieve.
 It ensures that appropriate individuals are made accountable for implementation of
the business.

Through the budget, top management communicates its expectations to lower level
management so that all members of the organization may understand these
expectations and can co-ordinate their activities to attain them. Therefore
communication takes place much more during the preparation stage.

4. THEY ASSIST IN MOTIVATION

Budgets produce a standard that in certain circumstances a manager may be
motivated, inspired.
However they can also encourage conflicts between managers

 Through participation, it assists managers in managing their departments and

it therefore acts as a strong motivational device which provides a challenge.
 However where a budget is imposed from above it becomes a threat rather
than a challenge and it can be resisted thereby doing more harm than good.
5. CONTROL

 T he budget assist managers in controlling and managing activities for which

they is responsible.
 It promotes management by exception.
6. PERFORMANCE EVALUATION

 Performance is evaluated by measuring his/her success in meeting the budgets

 Bonuses may also be awarded on the basis of an employee’s ability to achieve targets
specified in the periodic budgets or promotions may be partly dependent upon the
manager’s budget record.
 Budgets also provide a means of improving or measuring how managers are performing
in meeting targets that they previously helped to set.

BEHAVIOURAL ASPECTS OF BUDGETS

 Individuals react to the demands of budgeting and budgetary control in different
ways and their behavior can damage the budget process.
BEHAVIOUR PROBLEMS INCLUDES

 Dysfunctional and budget stock. Dysfunctional is whereby individual managers

seek to achieve their own objectives at the expense of goal congruence.
 The system of targets and measures used should then encourage goal
congruence
 Budgets slack/bias
QUESTION 4

You have recently been appointed as an assistant management accountant in large company,
Delta Beverages. When you meet the production manager, you overhear him speaking to one
of his staff, saying: “Budgeting is a waste of time. I don’t see the point of it. It tells us what
we can’t afford but it doesn’t keep us from buying it. It simply makes us invent new ways of
manipulating figures. If all levels of management aren’t involved in the setting of the budget,
they might as well not bother preparing one.

Required

4. Identify and explain six objectives of a budgeting control system. [13 marks]

5. Discuss the concept of a participative style of budgeting in terms of the six objectives
identified in past (a). [12 marks]


 - is a deliberate over –estimation of the expenditure and or under – estimation
of revenues in the budgeting process.
 This can happen because managers want easy target [for any easy life] or to
ensure targets is exceeded and bonuses won or simply to pay the system.